S&P’s sting may spread: Morgan Stanley

S&P 500 1,119.46 -79.92 -6.66%

NASDAQ 2,357.69 -174.72 -6.90%

TR US Index 101.39 -7.56 -6.94%

The investment bank’s warning came on the first trading day after Standard & Poor’s downgraded the country’s long-term debt rating from a perfect AAA to an AA-plus.

The ratings agency said a deal struck by Congress to avoid default fell short of what is needed to balance the U.S. budget over the long term and that the process is fraught with too much political risk.

The downgrade caused major U.S. indexes to fall 3 to 4 percent by Monday afternoon,following earlier stock market declines in Asia and Europe. The sell-off hit U.S. financial stocks hardest. Morgan Stanley was recently trading down 8.8 percent at $18.26.

The bank said in its quarterly regulatory filing that the S&P downgrade could further harm the U.S. financial markets and economy. As a result,the bank said its business,financial condition and liquidity could suffer,and that it might take more time to feel the downgrade’s full impact.

“Because of the unprecedented nature of negative credit rating actions with respect to U.S. government obligations,the ultimate impacts on global markets and our business,financial condition and liquidity are unpredictable and may not be immediately apparent,” the bank said in its 10-Q filing with the U.S. Securities and Exchange Commission.

Morgan Stanley said money markets,bonds,foreign exchange,commodities and equities could feel the effects of the downgrade,citing the potential for investors to post additional collateral on loans backed by U.S. Treasury bonds.

The bank also said that counterparties could ask for another $1.2 billion in collateral or termination payments if its own long-term credit ratings dropped by one notch and $3.3 billion if it dropped two notches. Morgan Stanley’s long-term debt is rated A by S&P and Fitch and A2 by Moody’s.

Brad Hintz,an analyst who covers brokerage stocks for Bernstein Research,said that while big banks will certainly see higher funding costs in overnight lending,known as the “repo market,” their cash reserves will blunt the impact of the downgrade.

He said Morgan Stanley and its investment banking counterpart Goldman Sachs Group Inc had more than $150 billion in excess liquidity as of June 30.

“These companies are awash in liquidity right now,” said Hintz. “Even if they can’t roll their commercial paper for a week or two weeks or even three weeks,they can just use balance sheet liquidity to fund themselves and that’s fine. Within a week or within a fortnight,they will be back.”

Morgan Stanley said doubts about the economic stability of Greece,Ireland,Italy,Portugal and Spain might further disrupt financial markets. The bank detailed $5 billion in gross funded exposure to those countries and $2 billion in net exposure after hedging.

The unusually detailed warning about sovereign risk was found within the “risk factors” section that Morgan Stanley typically outlines on an annual basis. The bank also warned about heightened regulatory risk,the potential for losses on real-estate assets and the chance that its joint ventures and acquisitions may not work out as well as initially planned.

The SEC has been pressuring banks to disclose more information about their risks to investors,particularly legal risk,and Morgan Stanley also disclosed $1.7 billion in possible losses related to subprime-mortgage related litigation.